The Nemtsov White Paper, Part II: Gazprom (Section 1)

La Russophobe has previously published a brief extract from the second part of the Nemtsov White Paper, dealing with Gazprom, edited by us from the English version that appeared in the Russian newspaper Novaya Gazeta. In doing so, we had to rely on NG’s translation of the substance, not an optimal scenario by any means. Now, our translator and columnist Dave Essel has undertaken to provide the entire work in English, as he did for Part I. Another benefit is that we now republish all Nemtsov’s illustrations, and as before we will publish this material in rolling installments and create an online PDF version, as well as a unified HTML document, after the final installment issues. Here is section 1.

Vladmir Putin: The Bottom Line
Part II – Gazprom

by Boris Nemtsov and Vladimir Milov

Translated from the Russian by Dave Essel

In February 2008, the authors of the report you are now reading published an independent expert report Putin – The Bottom Line in which they presented their views on what the Russian Federation’s second president had done for Russia. In Putin – The Bottom Line we gave an unflattering but in our view fair evaluation, backed up by facts and figures, of the outcome of Vladimir Putin’s activities for the country – an outcome that is hidden from Russian eyes behind a smokescreen of official propaganda – in such fields as the economy, the army, the pension system, health and education, roads and highways, and others.

A good number of readers rightly pointed out that there was one problem which we had only partially covered – Russia’s energy situation in general and the issue of Gazprom , Russia’s main energy company, in particular.

This was a deliberate omission on our part. We believe that the situation around Gazprom is worthy of individual attention and not something to be covered in just a few paragraphs.

This, firstly, is because Gazprom and what happens within it are of the utmost importance to our country. A second reason is because we have direct, first-hand knowledge of Gazprom’s problems because we were involved with it in our professional lives as former Russian minister of fuel and and energy and deputy minister of energy. Our last reason is that Gazprom has become a sort of personal special project of Putin’s: from the very beginning of his presidency he has carefully nurtured this corporation, appointed people close to him to key posts within it, and overseen its work in detail. Gazprom is one of only a few projects for which Putin can be considered to be personally responsible from the earliest days he was in power. One can, as a result, use it as a measure of the results of Putin’s doings.

In this report, we wish to enlarge on the analysis presented in Putin – The Bottom Line and examine what has happened with Gazprom over the years. If you are interested in the truth about this, read on….

Gazprom – Putin’s prime personal project

Gazprom is a unique phenomenon in Russia’s political and business life. Gazprom’s income in 2007 came to over $93 billion or 7% of Russian GDP. For perspective, note this is 2½ times the amount spent on defence. Gazprom accounts for over 12% of industrial production and about 16% of the value of Russia’s exports. Gazprom also accounts for 43% of Russia’s energy resources and consumption. Gazprom’s gas goes to make about 40% of the country’s electricity. In fact, it is the powerhouse of Russia’s economy: the stability and future of our economy actually depends on how well and reliably this corporation works.

Gazprom plays a key role in the world’s energy market. It produces 8.3% of the world’s oil and gas and supplies over 50% of the gas imported by EU countries.

No other corporation in Russia has such political and economic clout. Yevgenii Yasin {1} was spot-on when he called Gazprom “the government’s wallet”: nothing else can equal the corporation’s ability to concentrate financial resources and put them at the disposal of the Kremlin for important tasks.

Back in the 1990s, the Kremlin periodically used Gazprom to resolve political issues. For example, in 1997, when the government needed to pay off delayed pension payments, president Yeltsin instructed Gazprom’s managers to promptly pay off $2 billion of its pensions contributions arrears in order to finance the country’s pensions payments.

Under president Putin’s rule, however, Gazprom’s money has been used for quite other purposes. This is what we propose to describe in this white paper.

Gazprom has become Putin’s prime personal project. He set a greedy eye on the corporation as soon as he came to power. In fact, during the 2000 presidential campaign, it became clear that energy resources and Gazprom were at the top of Putin’s agenda. In June 2000, just a month after taking office, Putin arranged for the prompt replacement of Gazprom chairman Viktor Chernomyrdin by his brother-in-arms Dmitri Medvedev and in May 2001 replaced Rem Vyakhirev, who had headed Gazprom from its inception in 1992 with Aleksei Miller.

“Gazprom is more than just a joint-stock company. Russia’s whole economy is in a large part based on its gas industry” , said Putin at meeting devoted to the firing of Vyakhirev and appointment of Miller on 30 May 2001. {2} So there can be no doubt of his feelings about the corporation from the very start of his presidency.

Gazprom became the first business structure in which Putin by deliberate plan seized the commanding heights, in short order disposing his people into key posts while displacing all the old management team. Gazprom’s top ranks were rapidly filled with old Putin contacts from his St. Petersburg administration years. Today 11 of the 18 members of Gazprom’s board – all with important positions within the corporation, controlling finances, property, corporate management – are people who in the 1990s worked in the St. Petersburg administration, the privatised Port of St. Petersburg Authority, other Petersburg companies, or the FSB.

This is not the typical way in which global energy companies are run. Usually, leading positions are occupied by professionals with years of experience in top management in energy corporations. Former small-time regional bureaucrats, port and building company managers do not usually get given top management positions in major oil-and-gas corporations, especially in such numbers.

When making appointments to Gazprom, Putin (who without a doubt oversaw all this personally) was not demanding professionalism but rather looking for clan affiliation, for people from the “St. Pete clan”.

And we are not talking just about seizing the commanding heights of the company’s management: Putin devoted a considerable part of his every working day to internal Gazprom issues. Lobbying for Gazprom projects was high on his agenda at every international meeting and on foreign visits.

Putin nurtured the interests of Gazprom during the Russian government’s reviews of the regulation and development of the gas industry. When in 2002-2003 Mikhail Kasyanov’s cabinet attempted on a number of occasions to have gas industry reforms including the opening of the industry to competition put on the agenda, this was struck off each time at the Kremlin’s request. Despite more and more complaints (even by civil servants) about Gazprom’s unacceptably low tax payments, Putin has openly defended the corporation from having higher taxes imposed on it: the government has undertaken to maintain the current low level of taxes on it and not return to the matter until 2010.

With Putin’s approval, the government has signed off on a programme proving for sharp rises in the price Russian consumers pay for gas that will eventually lead to price parity with Europe. This had been lobbied for by Gazprom for 15 years but never got through under cabinet ministers Gaidar, Chernomyrdin, Kirienko, Primakov, and Kasyanov. This programme was passed by Mikhail Fradkov’s prime-ministerial decree #333 of 27 May 2007 and it will lead to internal prices for gas for Russian consumers to double from today’s price by 2011 – from today’s $64 per 1000 cubic meters to not less than $125. In fact, 2011 prices may be even higher than that since European gas prices have recently been sharply on the rise.

Throughout his years as President, Putin has been a very effective lobbyist for and defender of Gazprom’s interests.

Was this for the good of the country? Did Russians gain anything from the their president’s devoted attention to the country’s largest corporation?

Russia’s Gas Supplies – From Bad to Worse

The management inserted by Putin has been running Gazprom for over 7 years now so it is in no way unfair to see how they have coped and pass judgement. Their results are pathetic. First and foremost, Gazprom’s management has almost totally failed to make the corporation perform its main task – that of providing the Russian consumer with a reliable supply of gas. The idea was that Gazprom would get all its privileges, including its monopoly status and the active support of government, in exchange for delivering on this promise.

But no, Gazprom has to all intents and purpose not increased gas extraction over the whole period and in 2007 it actually fell back to nearly the 1999 level. Bearing in mind that some of the old gas fields are drawing close to empty, gas extraction may actually go from not just stagnating to actually dropping like a stone.

Table 1: Dropping like a stone

And Russian consumers have not had more gas delivered to them. Total supply to Russia’s internal market in 2007 was just 307 billion m3, just 2% more that the 2001 level. Over the same period, internal demand for gas has risen by 18% or 67 billion m3 per year!

So the gap between internal demand and gas supply is increased from 72 billion m3 in 2001 to nearly 132 billion cubic meters in 2007. Today, Russia is forced to get about one third of its gas fro non-Gazprom sources.

Table 2: Russia the gas importer

This gap has traditionally been filled by deliveries of gas from Russian independent producers and gas imports from the Central Asian countries. However, the independent producers have only a limited capacity to expand production and dependence on gas imports at rapidly rising prices from Central Asia is leading to a sharp rise in supply failures by Gazprom (more on this below).

The supply shortage on the internal market, exacerbated by Gazprom’s rising export obligations, is looking ever more of a threat. Gazprom has so far been unbelievably lucky with the weather: the last two winters have been relatively mild, leading to fewer demand peaks. However, favourable weather notwithstanding, demand in the peak winter months is rising.

This is indirectly illustrated by what happened in the last 2007-2008 winter season. With gas production stagnating, in January 2008 there was a sudden rise in gas withdrawals from underground storage. A record quantity of 50.1 billion m3 was required from storage, 20% more than in the three preceding winter seasons. By the end of January, Gazprom’s storage facilities stood practically at empty, this despite the fact that despite the start of production at the Yuzhno-Rossiisky gas field, the daily rate of gas production during winter 2007-2008 had grown by just 2-3% over the previous year.

Winter 2007-2008 brought a new record for gas taken from storage – 583.6 million m3 per day, beating the previous record set during the winter of 2005-2006.

This shows how much winter demand has risen during mild winters, so one can imagine the dreadful consequences awaiting Russia in the event that one of the forthcoming winters is a severe one. We can expect large-scale shut-downs of vital sites due to gas shortages.

We have already seen what happens then. Back in winter 2005-2006, consumers were faced with massive restrictions on gas supply. According to RAO UES (United Energy System of Russia), overall shortfalls of gas supply to power stations in the cold weeks of January-February 2006 were 12.5% under planned levels over the whole Russian power system and up to 80-83% for power stations located in the Central Region and the North-West. {3}

January-February 2006 also saw serious worries about gas supplies for export. According to the press, on 18 January 2006 Gazprom suddenly reduced the volume of transit gas passing through the Ukraine to Europe from 390 to 350 million m3 per day due to gas shortage. On the same day, Gazprom informed its Italian partner, ENI, that it was unable to guarantee full delivery of contracted gas due to the abnormal cold. Similar announcements were then made by Gazprom to Serbia (25% reduction of supply), Croatia (6-10%), and Hungary (20%). {4}

The stagnation in gas supply to the internal market despite rising demand is the result of systemic underinvestment in gas production. Russia has proven gas deposits sufficient to last it 80 years at current extraction levels. However, many of these deposits are not being worked. A goodly proportion of these deposits are located in new areas that have not yet been fully explored, lack the necessary infrastructure, and present extreme difficulties.

For example, before starting to work the gas deposits of the Yamal peninsula located some 500-600 kilometres from those already in operation (in the South of the Yamal-Nenets Autonomous Region), a railway 540 kilometres long must be built between Obskaya and Bobanenkovo, over permafrost and bogs, with an immense number of river and stream crossings. Gas from the Yamal peninsula will also have to be brought back by a 1100-kilometre pipeline from Bobanenkovo to Ukhta, the underwater part of which will have to cross Baidaratskaya Bay as well as traverse permafrost and bogs.

Under the licenses awarded to it, Gazprom was to have got production under way by the late 1990s but in reality nothing much was done about these deposits. In 2000, Gazprom former head Rem Vyakhirev asked for an extension to the licences. This was initially refused but after Aleksei Miller’s appointment to the helm of Gazprom, the licenses were quietly and without any explanation given extended for a further 8-10 years. Now even those timescales are being broken.

Against a background of falling production in the old gas fields, above all the Urengoi and Yamburg fields, both of which began producing in the 1980s, Russia is facing the worrying prospect of being short of gas. The Yuzhno-Russkoe gas deposit, the last relatively large deposit remaining in the currently exploited areas where the infrastructure is present and gas extraction is easier, went on line in 2007. From now on “new gas” is going to have to come from virgin regions that are amongst the most difficult in the world to work and where preparation work and infrastructure creation will demand immense investments. Gazprom estimates that the Bobanenkovo-Ukhta pipeline alone will cost $80-90 billion and the whole Yamal peninsula project something in the order of $200 billion – more than the total amount accumulated in the Russian Stabilisation Fund!

Why were these investments not made in good time? After all, the plan was for Yamal gas to start being pumped to the “mainland” in the late 1990s?

The trouble is that all this time Gazprom has been knowingly spending only relatively small amounts on investments in its main business of gas extraction. The vast windfall profits Gazprom got from the rapid growth of its exports and rising internal prices have been spent not on investments but on buying assets and financing ever-growing costs.{5}

Table 3: Ignoring the need to invest

So in the 7 years between 2001 and 2007, Gazprom has invested a mere smidgen over $27 billion on its core business of gas extraction.

Compare this with $44.6 billion spent on acquisitions. Of these, over $30 billion went to buy assets not connected with the gas business, above all to buy oil industry assets (Sibneft, Tomskneft) and electric power companies (RAO UES, Mosenergo, wholesale and local power generating companies), and also Rosukrenergo, the trading company.

Had these funds been put to use in readying the new deposits, there would be no gas supply crisis in Russia today.

And meanwhile, with the Yamal deposits not being brought online, Gazprom has become hooked on Central Asian gas. Back in 2002, Central Asian gas accounted for a little over 4% of the Gazprom’s gas. That is up to 8% today. Furthermore, this gas is getting steadily more expensive. In 2003, Turkmenian gas cost Gazprom $30 per 1000 m3; today it’s $150 and from 2009 that may be $250 or more.

It will come as no surprise therefore that Gazprom’s 2007 accounts prepared in accordance with international financial accounting standards show a paradoxical result: an 8% increase sales turnover is accompanied by an 11% drop in profits! This furthermore has taken place against a background of steadily rising gas prices in 2007 (22.5% for Russian consumers and an average of 25.2% for the CIS countries).

How can one at a time of rapidly rising prices simultaneously start making less profit? Gazprom’s management makes no secret of the fact that this is because of rising costs, of which one of the main constituents is the cost of buying in oil and gas from third parties. Gazprom’s spending on this has risen by 36%. In 2003, Gazprom purchases of oil and gas cost in all less than $1 billion. By 2007, they were spending $15 billion – which is more than one quarter of the whole corporation’s operating costs!

The greater part of this spending has gone on buying gas from Central Asia: $11.7 billion in 2007 as against $7.5 billion in 2006 and just over $1 billion in 2005.

In March 2008, the heads of the oil and gas corporation of Kazakhstan, Uzbekistan, and Turkmenistan announced to Gazprom that they intended from January 2009 to impose a new pricing system on the Russian monopolist with gas prices tied to European ones. This means that Gazprom may soon have to buy in gas at $250-$300 per 1000 m3 and spending on Central Asian gas may rise to $17-$21 billion a year.

Gazprom has yet another problem preventing it from increasing its investments in gas extraction: its shockingly low efficiency. Its operating costs (excluding taxes) have risen threefold since 2003 from $4.9 to $14.8 per barrel equivalent.

Besides its spending on bought-in gas (covered above), the other main reason for the increase is an increase in wages costs. These have risen from $3.7 billion in 2003 to $9.7 billion in 2007. Thus the cost of extraction of 1 barrel of oil equivalent has gone up from less than $1 per barrel in 2003 to $2.5 in 2007.

Gazprom’s number of employees has risen steadily – from 391,000 in 2003 to 445,000 in 2007. {6}

Table 4: Costs are exploding

Gazprom’s income was not sufficient to finance its growing appetite for asset purchases and its increasing costs As a result the corporation has gone deep into debt. It 2000, Gazprom carried debt of $13.5 billion. In 2007, Gazprom’s debt amounted to $61.6 billion – two-thirds of its annual income. (International oil and gas corporations generally think that a debt to income ratio of not more than 10-15% strikes the right balance.)

Table 5: Drowning in a sea of red ink

Massive repayment requirements prevent investment. To this one should add the risk that in the event of export prices becoming less favourable, the corporation may have to reduce investment still further or even become bankrupt. {7}

The likely result is that gas prices will rise still higher for Russian consumers, gas extraction will become still more crisis ridden, and the government may even have to step in with its resources to rescue Gazprom from bankruptcy.

This is how it happens that our gas underground gas resources, our national wealth, is not really helping the nation and is having its fate decided, including the decision to extract it or not, by a small circle of people linked to the powers that be.

NOTES:

(1) TN: economist and former Minister of Finance
(2) This statement comes from the website of the President of the Russian Federation
(3)Source: RAO UES Annual Report for 2006.
(4) Gas Rationing, article in Vremya Novestei, No. 7, January 2006
(5) Source: Gazprom: Explanatory note to Annual Report prepared according to international accounting standards.
(6) Source: Gazprom: Explanatory note to Annual Report prepared according to international accounting standards.
(7) Source: Gazprom: Explanatory note to Annual Report prepared according to international accounting standards.

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